The Rally in Perspective

Before you get ready to plow all of your remaining cash back into stocks, let’s put this in perspective. Stocks completed a terrific, four-week winning streak after a simply awful first 60 days of the year. This is not unusual action for a bear market. There is even a name for these violent moves higher, a bear market trap.

The reversal occurs when sellers become exhausted, and a bit of good news (or at least less bad news) emerges, forcing short sellers to cover their positions in a hurry. The higher prices force mutual fund mangers to rush in and buy, lest they miss any further gains. A “melt-up” can ensue where investors follow the herd and drive stocks even higher.

The problem with these types of market moves is that we do not know if the rise in stocks represents the long-awaited recovery or a major head fake, which lures investors back in, only to crush them later when prices fall back to where they were at the lows.

The current melt-up has seen the Dow Jones Industrial Average rise from the March lows of 6,547 to over 8,000. If you are keeping score, that amounts to a smart 21 percent recovery from the low point.

Feeling good about those gains? Sorry to be the bearer of bad news, but we are still down 44 percent from the October 2007 high. And the 11th recession since World War II is on track to become the longest on record, with few signs of a turnaround emerging.

Want some good news? The U.S. economy will be more than able to survive this recession, and so too will you. Recessions are a natural part of the economic cycle, and we should all stop worrying about when exactly this one will end. Instead remind yourself that it will, in fact, end.

That does nothing to address the severe damage on your portfolio, does it? Well, if you are still in the accumulation phase of your life, market pull-backs actually benefit you in the long run. Conversely, if you are about to retire or are already retired, then you should not be invested aggressively enough that a sell-off would blow up your long-term plans.

The problem is that many investors have short memories. Time and time again, as investors swing between extreme fear and greed, they can often be their own worst enemies. That’s why the average stock mutual fund investor has not performed as well as stock indexes.

The research firm Dalbar conducted a survey called Quantitative Analysis of Investor Behavior, which compared the annualized return for the Standard & Poor’s 500 index to the average stock fund investor from 1986 through 2005. During this time frame, the index returned 11.9 percent, while investors returned 3.9 percent. An 8 percentage point differential is amazing!

I attribute this huge performance gap to the oldest lesson in the investment book: investors can be led astray by their emotions. When people see that asset prices are dropping, they are tempted to sell. When they are rising, investors pile in. In other words, they sell low and buy high.

How can you manage your money, and emotions, during these trying times? There are three distinctive steps that help seasoned investors withstand the ups and downs of the market. You know these deep down, but it’s worth a reminder, especially amid the volatile swings that are likely to persist in securities markets.

• 1. Remind yourself, you do not need to buy the bottom or sell the top to be a successful investor. Rather, you need to adhere to a diversified portfolio that will allow you to stay in the market even when it feels scary at the bottom and not to pile on too much risk when the good times are rolling.
• 2. Do not make a major investment decision intra-day. If the idea is a good one, then an extra 24 hours of thought will not hurt, and may prevent you from executing a reactive trade that is catalyzed by market movement only.
• 3. Remember that nobody really knows what is going to happen in the short-run. So, do not fall prey to bull market cheerleaders or bear market Cassandras.